Abstract
Chinese VIE Internet companies are among the most popular among foreign investors. These have a total market capitalization of 841 billion dollars as of March 31, 2022. Proportionally, to understand the extent of the effects in the event of their "forced dissolution", the amount is 6 times larger than that of 130 billion which spawned US-based Enron when it suddenly went bankrupt in 2001.
The PRC legally prohibits foreign direct investment in certain sectors. To get around these restrictions, mainland Chinese companies interested in raising funds on US stock exchanges (e.g. via IPOs) create offshore business entities for foreign investment using the Variable Interest Entity (VIE) structure.
This is a structure in which an offshore shell entity, usually in the Cayman Islands, is owned by investors in the United States or Hong Kong. This offshore entity only has a contractual relationship with the Chinese mainland company and is not its owner: in fact, VIE shareholders do not purchase ownership shares of the Chinese company but, generally, only a right to participate in its profits, through offshore hedging.
President Joe Biden had signed the executive order on June 3, 2021, designating 59 companies linked to China's defense and surveillance industry. The order still prohibits US investments from supporting the Chinese military-industrial complex: military, intelligence and security research and development programs, and production of weapons and related equipment. In fact, the Chinese Communist Party, through its aggressive national “military-civilian fusion” strategy, uses Chinese companies to strengthen the People's Liberation Army.
The Intelligence Law of 2017 states that “any organization or citizen will support, assist and cooperate with state intelligence work” and the Cybersecurity Law of 2017 requires companies to “provide technical support and assistance to public security bodies” . The CPC Opinion on Strengthening the United Front Work of the Private Economy in the New Era, published on September 15, 2020, highlights the importance of the CCP's control over the private economy, including private entrepreneurs.
To address this, the United States has recently extended its national security perimeter to include some high-end technological goods, such as certain types of chips, classified by the government. In this difficult geopolitical phase, important think tanks, universities, observers and politicians have even begun to suggest that the US administration progressively extend this perimeter to the entire economy, to counter Beijing's illegitimate advance.
by Nicola and Gabriele Iuvinale
Investing in Chinese companies may involve various risks also associated with the legal, regulatory and financial environment. For example, the legal framework of Variable Interest Entities (VIEs) in China is highly controversial and subject to the jurisdiction of the CCP-controlled courts in Beijing. The PRC, in fact, legally prohibits foreign direct investment in certain sectors, including many high-tech ones, and maintains strict controls on foreign exchange and capital flows. To get around these restrictions, mainland Chinese companies interested in raising funds on US stock exchanges (e.g. via IPOs) create offshore business entities for foreign investment using the Variable Interest Entity (VIE) structure.
This is a structure in which an offshore shell entity, usually in the Cayman Islands, is owned by investors in the United States or Hong Kong. This offshore entity only has a contractual relationship with the Chinese mainland company and is not its owner: in fact, VIE shareholders do not purchase ownership shares of the Chinese company but, generally, only a right to participate in its profits, through offshore hedging. This would circumvent Chinese laws that ban foreign capital in areas such as telecommunications, news and internet media. Since foreign investors own the offshore shell company, instead of the actual Chinese company, this creates a high risk for financiers. As mentioned, the VIE structure was created to circumvent the Chinese law on "Special Administrative Measures for Access to Foreign Investment (Negative List)", where 33 rules are listed, with the most relevant ones at numbers 16 and 17, which prohibit the entry of foreign capital into Chinese Internet news service companies, publishing, Internet radio and Internet TV (except music). This is why the VIE structure is more popular among Chinese technology and Internet companies.
With a VIE entity, a company can therefore also list in Hong Kong or the United States without seeking approval from the Chinese regulator. If DiDi had delayed the listing of its VIE structure in the USA and had instead done so in Hong Kong, according to the government's wishes, it would not have attracted the severe response from the Beijing authorities, which then led to its delisting.
Generally, the VIE structure has been recognized as suitable in the United States by GAAP accounting standards, a common set of accounting rules and procedures issued by the Financial Accounting Standards Board (FASB), and Moody's rated its default risk as low in 2014. However, since 2017, the Council of Institutional Investors (CII) has warned sternly about increased risk and called on the SEC to strengthen disclosure guidelines. There are over 100 Chinese companies listed in the US with a VIE structure and many in Hong Kong. The most well-known Chinese Internet companies, such as Tencent, Alibaba, Pinduoduo, Baidu, JD and NetEase, all operate under a VIE structure.
The current VIE is based on two sets of rules: those of foreign ownership and listing approval. To ensure that situations like DiDi's do not happen again in the future, the China Cyberspace Administration (CAC) has issued rules that any company with more than one million users must undergo a cyberspace audit before going public. abroad. This would implicitly confirm both the foreign ownership ban rule and the incompatibility of the VIE structure. Nonetheless, the Beijing government could continue to leave this gray area alive, as it has done for the past 20 years, tacitly acknowledging that VIE facilities are not in fact foreign-owned and would therefore not be breaking China's laws on related bans. Or, it could impose a limit on foreign ownership and require the dismantling of the VIE structure. As it circumvents the prohibitions imposed by the CCP, it could be considered illicit and, consequently, the relevant contract would be null and void and could be dissolved automatically by Chinese regulators or the judiciary, in the event of a dispute between partners.
Based on the latest annual report, 184 Chinese companies listed on the three major US stock exchanges use a VIE. These have recently become particularly risky for both investors and shareholders of the offshore special purpose vehicle. If the Chinese mainland entity decides to no longer respect the contract that binds it to the VIE company, legal action will have to be taken. And here the problem arises since these contracts are generally subject to Chinese law and the Beijing courts have repeatedly ruled, especially in recent times, that VIE contracts are illegal and unenforceable. This means that shareholders could lose all of their investment.
For example, in 2011 Jack Ma took (Chinese) Alipay out of the Alibaba Group (which has its own VIE), out of fear that the Chinese regime would ban foreign investors from owning a “third-party payment transfer” company. Alibaba's VIE was largely owned by Yahoo and Softbank, but they did not know that Ma had meanwhile moved Alipay out of the Alibaba Group in China until after the fact, even though Yahoo believed it had ownership. Investors were given pennies in compensation. Subsequently, the Alipay/Ant Group IPO was also blocked by Chinese regulators, showing the risks associated with investing in VIEs. Ironically, VIE Internet companies are among the most popular among foreign investors. These have a combined market capitalization of $841 billion as of March 31, 2022.
Proportionally, to understand the extent of the effects in the event of a forced dissolution, the amount is 6 times larger than the 130 billion that the US Enron generated when it suddenly went bankrupt in 2001. The event came completely unexpected as it was officially Over the last ten years, the company had experienced very rapid growth, increasing its value tenfold and reaching 7th place in the ranking of the most important multinational companies.US nationals. However, within a very short time Enron shares, considered by all to be very solid, lost all their value, going from a price of 86 dollars to 26 cents, thus burning approximately 130 billion dollars in the space of three months. The discovery of the network of companies linked to Enron that the executives had built in some tax havens contributed to worsening the situation. There were a total of 881 companies, of which more than 600 were in the Cayman Islands. VIE agreements between mainland companies and their associated offshore entities have a highly questionable status under Chinese laws and, consequently, could cause significant damage to the shareholders and economies involved. In February 2021, the State Administration for Market Regulation (SAMR), the ministerial-level agency directly under the control of the State Council of the People's Republic of China charged with regulating areas such as market competition, monopolies, intellectual property, and security of drugs, issued new guidelines, expressly establishing that VIEs are formally covered by China's anti-monopoly rules. With 71% of all Chinese companies listed in the United States, the percentage of those using the VIE structure appears to be increasing. In March 2019, a survey found that 68.7%, or 125 of the 182 Chinese companies listed on the NYSE and NASDAQ, used the VIE structure.
The Public Company Accounting Oversight Board (PCAOB), established by Congress to oversee audits of companies listed on US stock exchanges, is currently unable to inspect the working papers of auditors based in the PRC and Hong Kong. In 2013, the PCAOB signed a Memorandum of Understanding (MOU) on audit oversight with the China Securities Regulatory Commission and China's Ministry of Finance. However, in the eight years since, the Chinese government has never allowed China-based audit firms to comply with US audit inspection law.
The PCAOB and the U.S. Securities and Exchange Commission have repeatedly expressed concern about barriers to inspecting foreign auditors. In 2021, the PCAOB reported 223 audit reports issued in jurisdictions where authorities deny access to conduct inspections; 166 were from China and 57 from Hong Kong. This failure to comply with international audit inspections calls into question the reliability of the company financial statements that guide the valuation and investment. Furthermore, as a further measure by the US government against listed Chinese companies, the Office of Foreign Assets Control of the US Department of the Treasury (OFAC) issued new guidelines on the military companies sanctions program on June 1, 2022 - Chinese industrial companies listed by the government (CMIC Securities).
The new guidance states that “Americans are not required to divest their holdings of CMIC securities during the 365-day divestment period and may continue to hold the securities after that period.” TutHowever, US investors will be prohibited from disposing of any holdings in CMIC securities after the end of the divestment period.
President Joe Biden had signed the executive order on June 3, 2021, designating 59 companies linked to China's defense and surveillance industry. The order still prohibits US investments from supporting the Chinese military-industrial complex: military, intelligence and security research and development programs, and production of weapons and related equipment. In fact, the Chinese Communist Party, through its aggressive national “military-civilian fusion” strategy, uses Chinese companies to strengthen the People's Liberation Army.
Investors in Chinese companies may also support activities contrary to US national interests, including the development of technologies used for censorship, surveillance and to support the military. “For example, Weibo Corporation is currently valued at $5.8 billion. Weibo works at the direction of the government to censor posts on its blog platform and is used by central and local governments to survey and censor public protests.”
Private companies in China are also subject to state pressure and control. The Intelligence Law of 2017 states that “any organization or citizen will support, assist and cooperate with state intelligence work” and the Cybersecurity Law of 2017 requires companies to “provide technical support and assistance to public security bodies” . The CPC Opinion on Strengthening the United Front Work of the Private Economy in the New Era, published on September 15, 2020, highlights the importance of the CCP's control over the private economy, including private entrepreneurs.
To address this, the United States has recently extended its national security perimeter to include some high-end technological goods, such as certain types of chips, classified by the government. In this difficult geopolitical phase, important think tanks, universities, observers and politicians have even begun to suggest to the Biden administration to progressively extend this perimeter to the entire economy, to counter Beijing's illegitimate advance.
Citation
Nicola and Gabriele Iuvinale, "Xi Jinping's China. Towards a New Sinocentric World Order?", Antonio Stango Editore, 2023.
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